What Financial Ratios Can Tell You
A good set of financial records are a must when considering economic decisions in your operation. Understanding how to pull the needed data out of those records and interpreting them is key to providing you with the information that can be used to make your decisions. The five areas of financial performance outlined in the February 2017 Ag News and Views article, "Three Financial Records to Help You Make Better Decisions," have ratios or calculations that can be used to benchmark the operation. While there are more than one or two indicators for each performance area, this article will only show the ones we use most in our evaluations at the Noble Research Institute.
The most common measurement for liquidity is a current ratio. Current assets are things that are cash or are expected to be sold within a year's time. This could include the cash you currently have or crops and livestock you expect to sell. Current liabilities are the debt payments upcoming within the next year. A good current ratio to strive for is 2.0. This shows you have twice as many current assets as you do current liabilities. As this ratio moves closer to 1.0, the ability to pay outstanding debts becomes more strained.
- Current Ratio = Total Current Assets ÷ Total Current Liabilities
Measuring for solvency can be achieved by looking at the debt-to-asset ratio. This ratio can tell you how much of the operation is owned by the operator. This is something lenders consider when evaluating the level of risk they would be taking on when issuing a loan. A good midpoint for this ratio is to have a total debt of half of the total assets, or a ratio of 0.5. A good goal is to have a debt-to-asset ratio of 0.3 or less.
- Debt-to-Asset Ratio = Total Operation Debt ÷ Total Operation Assets
Calculating profitability uses two different numbers. The first is the net farm income. The higher the net farm income, the larger the profitability of the operation. While this number is good for comparing an operation over time, a good net income for one operation could be terrible for another.
- Net Farm Income = Gross Income (total income or revenue without anything taken out) – Cash Farm Expenses +/– Inventory Changes – Depreciation
A rate of return-on-assets, or ROA, is used to show how well an operation's assets create income. A ROA of 0.01 or less indicates the assets are not creating a desirable level of profit to the operation. A good ROA is considered to be 0.05 or greater.
- Return on Assets = (Net Farm Income + Farm Interest – Value of Unpaid Family Labor or Management) ÷ (Average of Beginning-of-the-Year Total Farm Assets and End-of-the-Year Total Farm Assets)
Repayment margin coverage ratio is a measurement for replacement capacity. This provides a measure of your operation's ability to cover debt requirements. This is similar to solvency, however it takes into account off-farm income, living expenses and taxes. This number needs be greater than 1.0, but a number greater than 1.5 shows the operation has the ability to handle times of unfavorable markets.
- Replacement Margin Coverage Ratio = (Net Farm Income + Depreciation + Net Nonfarm Income – Family Living and Income Taxes + Interest Expense on Term Loans) ÷ (Scheduled Principal and Interest on Term Loans + Unfunded Capital Replacement Allowance)
There are three different ratios that can help you evaluate financial efficiency. An asset-turnover ratio shows how the assets of the operation are creating value.
- Asset-Turnover Ratio = Value of Farm Production ÷ Average Farm Assets
An interest-expense ratio shows how much of the operation's gross income is going to interest. Ideally, this number should be less than 0.1.
- Interest-Expense Ratio = Amount Spent on Interest ÷ Gross Income
Last is the net farm income ratio, which lets you see how much of the operation's income is being retained by the operation. A ratio of 0.2 or greater indicates a strong net farm income ratio.
- Net Farm Income Ratio = Net Farm Income ÷ Gross Farm Income
While these ratios are good indicators, they are only that – indicators. The levels mentioned above are starting points to work with. Each operation is different and will have different needs. An operation might have a low current ratio, but what isn't shown in that number is the operation has a more steady cash flow, like a dairy or poultry operation. An operation that is just getting started would be expected to have a much higher level of debt than an operation that has been going for the last 40 years. By looking at the information provided by your financial records, you can better plan for the future of your operation.